Emotional Investing : @ High Cost

Most investors are no doubt familiar with the standard disclaimer “Past performance is not indicative of future results.” This compliance truism tends to stay in the fine print, both on paper and in investors’ minds, when they make decisions on the basis of real-time market dynamics.

Even if investors purport to buy into the logic of the “random walk” argument about security prices, in practice they tend to extrapolate recent history into the future (termed recency bias in behavioral finance) when making portfolio decisions — for example, believing that if stock prices have gone up recently, they will continue on that upward trajectory. When the desire to chase returns goes unchecked, investors often engage in aggressive trading. But do they end up better off for their efforts?

It is interesting to note the extent to which the general outcome is also driven by a factor over which investors, in principle, have complete control: their own behavior. Indeed, fully 1% of the investor’s underperformance relative to the asset class can be attributed to trading activity. Attempting to time the market and not doing a very good job of it.

Investors underperformed the funds themselves because of their tendency to exit before gains and enter before losses (and even sometimes to lose money in bull markets as a result of exquisite mistiming) and would have been better off simply staying put in the S&P 500 without any attempt to time the market. No wonder investment sage Warren Buffett, in a play on Sir Isaac Newton’s laws of motion, has said, “For investors as a whole, returns decrease as motion increases.”

To conclude

Investors chase returns and harm themselves by doing so. They chase returns by allocating more to funds that perform well in a mistaken belief that past performance will persist. Simply by doing the opposite of what investors instincts tell them to do, investors could earn — rather than lose — an extra🙂